Dating back to the early 1990s, large shareholders have used variable prepaid forward contracts (VPFCs) to sell their stock, receiving money upfront but not paying tax until years later when they actually deliver the stock to the purchaser.

In 2003, the IRS issued a ruling allowing this type of transaction, but recently it has begun investigating them again, concerned that shareholders and their advisers were taking advantage of the rules. As a result, if you have entered into a VPFC since 2002, but especially since 2004, be wary — the IRS may be looking for you.

A VPFC is, essentially, a hedging position for an owner of stock. For example, assume that a shareholder who owns 1,000 shares of Google thinks the price is too high and is concerned that selling it would prevent future gains on increases. In addition, he needs additional cash for unrelated reasons and wants to diversify a stock portfolio. The shareholder enters into a VPFC, agreeing to sell the Google stock to a buyer in three years.

The buyer pays the shareholder now the market value for the 1,000 shares of Google. In three years, on the settlement date, the seller delivers to the buyer a variable amount of Google stock — the amount of stock that is actually delivered depends on the price of the Google stock on the settlement date. The seller received the sale proceeds up front, but only has to pay tax on the sale when the stock is delivered to the buyer, years later. In addition, because the amount of Google stock the seller must deliver to the buyer varies depending on the price of Google on the settlement date, the seller has limited the risk of loss, although the seller has also capped the potential for gain.

In 2003, the IRS issued a ruling blessing this type of VPFC. The IRS established a variety of rules that sellers must follow. All of the rules are focused on a single idea — the seller must retain the “benefits and burdens of ownership” of the stock until the stock is delivered to the buyer. That is the key — under IRS rules, whomever has the “benefits and burdens of ownership” of the stock is the owner. So as long as the seller retains the “benefits and burdens of ownership” of the stock until delivery, the sale will not be taxed until the year the stock is delivered, even if the seller received the proceeds from the sale years earlier.

Over the last year or two, however, the IRS has begun a comprehensive investigation into the use of VPFC transactions. The IRS is concerned that the transactions may have features similar to abusive tax shelters. In February, the IRS issued a lengthy technical analysis of VPFC transactions describing problems it has discovered, the law it believes applies and how it will audit taxpayers who have engaged in VPFC transactions.

One of the major concerns by the IRS is that the buyers of the stock, often investment banks, will protect themselves against potential losses in the value of the stock by hedging the stock they are purchasing, often through short sales. Although the bankers claim they are only borrowing the shares placed in escrow by the selling shareholders, the IRS argues that the investment bankers’ use of the pledged stock shows that they have obtained all of the “benefits and burdens of ownership” of the pledged shares — resulting in an immediate sale, rather than a deferred sale, and therefore requiring the seller to pay taxes immediately, rather than years later when the stock is delivered to the buyer.

The IRS has begun a large-scale audit program focused on taxpayers who have engaged in VPFC transactions. The initial letter from the IRS advising taxpayers they are under audit is followed immediately by a letter with 27 separate requests for information; many of the requests for information have multiple subparts. Taxpayers under audit not only need to have access to the documents related to the VPFC, but also the ability to obtain a variety of other information from the adviser that brokered the VPFC and the buyer of the stock. In addition, taxpayers under audit need to understand the technical and complex law surrounding the taxation of VPFC. It is not an easy area to navigate, and the wrong step will not only result in additional tax, but interest and potentially penalties as well.

For years shareholders have used VPFCs as a routine method for obtaining immediate cash, diversifying assets, all while deferring tax liability. VPFCs can still be an important part of a well-rounded stock strategy if they are done correctly. But if you have done a VPFC in the last six years, it may not have been done correctly — and if it wasn’t, you shouldn’t be surprised to get a letter from the IRS.

Brian Bernhardt is a partner in the Richmond office of McGuireWoods LLP. He practices in the areas of Federal tax controversies, Federal tax litigation, and nonprofit and tax-exempt organizations, focusing on their administrative relationships with the Internal Revenue Service.